POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise APRIL 2012 • Number 79 UN 010 • Numbe 1 68145 European Bank Deleveraging: Implications for Emerging Market Countries Erik Feyen, Katie Kibuuka, and Inci Ötker-Robe Just before the 2008–9 global financial crisis, policy makers were concerned about the rapid growth of bank credit, particu- larly in Europe; now, worry centers on a potential global credit crunch led by European banking institutions. While recog- nizing that concrete evidence is limited by significant data gaps and lags, this note discusses the dynamics of European bank deleveraging and possible implications for emerging market economies (EMEs). Overall, the information available as of early 2012 shows a marked deterioration of credit conditions across Europe. Data also suggest that spillover effects are already being felt around the globe and imply significant channels through which deleveraging could have disruptive short- and long-term consequences for credit conditions in EMEs, particularly in Central and Eastern Europe (CEE). However, the significant liquidity support provided by the European Central Bank (ECB) since December may be a “game changer,� at least in the short term, because it has helped revive markets and limited the risk of disorderly deleveraging. The extent, speed, and impact of European bank deleveraging will henceforth depend largely on the evolution of market conditions, which in turn are guided by the ultimate impact of ECB liquidity support, attainment of sovereign debt sustainability and fiscal convergence within the euro zone, and credibility of the European rescue fund as an effective firewall against contagion. Scope and Drivers of European Bank by increasing equity (on average by about 20 percent) to ease Deleveraging market concerns about their solvency and to prepare for Basel III. At the same time, they cleaned up their balance sheets and Just before the 2008–9 global financial crisis, policy makers reduced assets by an average of 10–15 percent by selling non- were concerned about the rapid growth of bank credit in Eu- strategic assets, exiting from businesses subject to higher rope that uncovered serious fault lines in the financial system. capital requirements, and reducing lending across virtually The 2008–9 financial crisis demonstrated that European all regions. banks had been operating under an unsustainable business The significant funding and solvency pressures that Euro- model that relied on thin layers of capital (that is, high lever- pean banks have been facing since last fall have raised concerns age) and short-term wholesale funding to support rapid cred- that a simultaneous and disorderly adjustment in bank balance it expansion both domestically and across borders. As regula- sheets could result in massive deleveraging and a credit crunch tors around the world launched extensive reforms to create with global spillover effects. Notwithstanding the ongoing pro- more resilient financial systems, European banks responded cess of balance sheet adjustment, European banks remain high- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise ly leveraged, with their median asset values at almost 19 times trenchment of U.S. money market funds in the latter half of equity (figure 1). Although many European banks have re- 2011 and elevated dollar-euro swap costs. Second, the EBA’s duced their loan-to-deposit (L/D) ratios (by about 36 percent- recapitalization requirement introduced in late 2011 required age points on average from 175 percent in the first quarter of European banks to raise core tier 1 capital ratios to 9 percent by 2007), their reliance on wholesale funding remains high (fig- June 2012. A number of national regulators (Austria, Sweden, ure 2). As such, gradual deleveraging is needed. However, while United States, and United Kingdom) also introduced country- plans to scale back activities may be justified at an individual specific measures that would effectively tighten or bring for- bank level, they become a concern if they occur simultaneously ward the implementation time table of Basel III capital require- and induce fire sales and an adverse cycle of liquidity and sol- ments.1 While the European Banking Authority (EBA) has vency problems that could impede the provision of productive taken mitigating measures to limit the extent of deleveraging credit. Damaging spillover effects could further diminish glob- and avoid retrenchment of banking groups from host coun- al economic prospects at a time when flexibility of fiscal or tries, preliminary capitalization plans submitted end-January monetary actions in some countries is limited. 2012 are still undergoing a validation process by the EBA and A number of recent developments heightened concerns national supervisors.2 Last, further deepening of the euro debt about the risk of acceleration in the deleveraging process. First, crisis and deterioration of the economic outlook would reduce a negative feedback loop between bank, sovereign, and real sec- bank earnings and raise nonperforming loans (NPLs), which tor risks, combined with large bank and sovereign refinancing would restrain banks from strengthening capital through re- needs in 2012–15, is keeping funding conditions tight and tained earnings, inducing further deleveraging. putting pressure on banks to reduce balance sheets. European Prior to January 2012, many European banks had an- banks also face dollar shortages, as illustrated by a sharp re- nounced plans to meet the new capital requirements through means other than raising fresh capital. Arguing that acquiring Figure 1. Bank Leverage by Region capital from the market is difficult in an environment with low 25 profitability and weak investor interest in European banks, many banks reported they would meet the capital target with a 20 combination of: retained earnings; management of risk-weight- asset-to-equity ratio ed assets (RWAs), including cutting activities with high risk percentage 15 weights and reassessing the models used to generate risk 10 weights; engaging in asset-liability management; and shrinking balance sheets, including by divesting noncore operations in 5 various jurisdictions to focus on core markets and cutting jobs in certain locations and business units. Only a few banks have 0 so far raised capital through rights issues. A worst-case scenario Asia CEE MENA SSA Latin Europe other of meeting the requirement only by shrinking balance sheets America �rst quarter 2007 fourth quarter 2010 would imply shedding €3.6 trillion or 10.5 percent of total Source: Bankscope, Bureau van Dijk; Europe data from European Central Bank bank assets.3 Consolidated Banking Statements. Moreover, driven by more prudent risk management prac- Note: MENA = Middle East and North Africa; SSA = Sub-Saharan Africa. tices, European banks have been tightening lending standards. Figure 2. Dependence on Wholesale Funding by Region ECB’s latest lending surveys show that in the fourth quarter of 200 2011, credit conditions worsened significantly across the euro 180 zone (figure 3). Key drivers were a deteriorating economic out- 160 look, limited access to market financing, and tight liquidity 140 loan-to-deposit ratio conditions (figure 4). Banks expected further deterioration of percentage 120 credit conditions in the first quarter 2012. Indeed, after a re- 100 cord plunge in the last quarter of 2011, bank lending to firms 80 and households improved only marginally. The latest ECB re- 60 40 port on monetary and financial developments show that an- 20 nual lending growth to the private sector has continued its 0 downward path, growing at 0.7 percent in February, compared Asia CEE MENA SSA Latin Europe other to 2.6 percent in 2011:Q2, with nonfinancial corporate credit America growing by 0.4 percent from a year ago. Unprecedented liquid- �rst quarter 2007 fourth quarter 2010 ity provided to banks through the ECB’s long-term refinancing Source: IMF, International Finance Statistics; Europe data from European Central Bank Consolidated Bank Statements. operations (LTROs) in end-December and February is estimat- 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 3. Bank Lending Conditions in Europe, January 2003–January 2012 down 6 percent in the first nine months of 2011, compared to of banks reporting tight conditions 2010. Arguably, this was partially a result of European banks’ limited access to U.S. dollar funding; European banks account 70 weighted net percentage 60 for about one-third of the trade financing market, with large 50 French banks providing a significant share in emerging Europe, 40 Asia, Latin America, and West Africa. Anecdotal information 30 also suggests that trade financing experienced significant de- 20 10 clines in some regions in end-2011 (for example, Hong Kong 0 SAR and Singapore), partially reflecting funding difficulties. 10 European banks also have significant presence in aircraft and 20 car leasing/shipping, which many banks are reportedly seeking 30 to sell. Nov 03 May 06 Nov 08 May 11 Jul 05 Jul 10 Jan 03 Sep 04 Feb 05 Mar 07 Jan 08 Sep 09 Feb 10 Jun 03 Apr 04 Dec 05 Aug 07 Jun 08 Apr 09 Dec 10 Oct 06 Oct 11 The latest data from the Bank for International Settle- ments (BIS) suggest that lending cuts by European banks fo- �rms household mortgages other household credit cused primarily on dollar-denominated loans and loans with Source: European Central Bank Survey. higher risk weights. In particular, European banks reduced funding contributions to new syndicated, bilateral leveraged- Figure 4. Drivers of European Lending Conditions, and project-finance loans between the third and fourth quar- January 2003–January 2012 ter of 2011 (figure 5). Banks with EBA capital shortfalls re- duced their lending sharply for all categories—especially respondents reporting tightening conditions leveraged loans, aircraft/ship leasing, and project and trade 200 weighted net percentage of bank factors affecting credit conditions finance. The BIS also notes, however, that increased financing 150 from other banks, asset managers, and bond market investors largely compensated for the cuts by European banks in the 100 third quarter of 2011, leaving the overall volume of new syn- 50 dicated and large bilateral loans essentially the same as in the third quarter of 2011. Trade financing seems to have been 0 picked up by Asia-based and other lenders, helping to limit its overall decline. -50 While only a limited amount of ECB liquidity has so far Jun 03 Apr 04 Jun 08 Dec 05 Aug 07 Apr 09 Dec 10 Oct 06 Oct 11 Nov 03 May 06 Nov 08 May 11 Jul 05 Jul 10 Jan 03 Sep 04 Feb 05 Mar 07 Jan 08 Sep 09 Feb 10 found its way to the real economy, liquidity operations are be- lieved to have reduced the risk of disorderly deleveraging. The capital positions access to market �nancing ECB’s two three-year LTROs provided more than €1 trillion of liquidity position economic outlook gross loans to banks in the region, and are believed to have Source: European Central Bank Survey. Figure 5. Changes in New Lending by Type of Lender and Loan ed to have been used mostly to fund a profitable carry change in new lending between trade to purchase high-yielding bonds, particularly sov- all loans Q3 2011 and Q4 2011 ereigns, with the full supportive impact on lending ex- pected to take some time to unfold. US$ denominated all lenders worldwide Limited information suggests that certain areas of other EU lenders banking are being hit harder than others. Less profit- trade �nance weaker EU banksa able, capital-intensive projects are disproportionately affected, including infrastructure finance and loans to project �nance small and medium enterprises (SMEs). The latest ECB lending survey suggests that SMEs are experiencing dif- aircraft/ship leasing ficulties in accessing bank credit across Europe. High lending rates are also discouraging UK SMEs from bor- leveraged rowing from banks, which reportedly failed to meet their SME lending targets. Access to credit is known to 5 -5 -15 -25 -35 -45 percent be particularly difficult for SMEs in CEE and Central Source: Bank for International Settlements Quarterly Review, March 2012. Asia. Similarly, global trade financing volumes were a. The 31 banking groups with capital shortfalls in the EBA exercise plus all Greek banking groups. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise averted an extreme fire sale scenario (or a disorderly shedding ticularly where host countries lack well-developed capital mar- of assets) and a subsequent credit crunch in Europe by improv- kets and alternative sources of nonbank financing. ing bank funding conditions, boosting market confidence, and Notwithstanding the slowdown in their growth, Europe- jumpstarting lending activity in the interbank market. The im- an banks’ foreign claims on EMEs remain large, suggesting that proved euro funding conditions, combined with last year’s de- disorderly retrenchment can have adverse consequences. cision by major central banks to cut the cost of their dollar swap Claims5 grew rapidly during 2005–8 and are a dominant lines, also helped improve dollar funding costs, mitigating the source of international funding relative to those provided by impact on dollar-denominated loans. other BIS reporting banks. In the third quarter of 2011, Euro- At the same time, there are signs that additional risks may pean banks had US$3.9 trillion in international claims on be emerging, partly in response to the tightening of regulatory emerging market and developing countries, down by US$234.5 requirements for banks and reduced bank credit. Signs of dis- billion from a quarter earlier—the largest drop since the 16 per- intermediation in the euro zone have become evident, with cent contraction between first quarter 2008 and first quarter large European companies faced with markedly higher fees 2009. Despite the slowdown, and a corresponding decline in and margins on bank loans increasing their reliance on bond their share, European banks’ foreign claims on EMEs remain and capital markets since the crisis. There is also anecdotal evi- high, particularly for the CEE region, where they make up 60 dence of risk being squeezed out of banks into the shadow percent of recipients’ gross domestic product (GDP; with large banking system as banks are discouraged from engaging in cer- variation within the region; figures 6 and 7). Emerging Europe tain (riskier) activities. Banks have also been engaging in deals is particularly exposed to a possible retrenchment, with a high with private equity and hedge funds to preserve bank capital, median L/D ratio of almost 120 percent in third quarter 2011 by slicing various exposures and repackaging and shifting and relatively shallow capital markets. Available information them from their balance sheets. Despite its growing impor- suggests that supply-side problems are so far limited to some tance, the shadow banking system is not regulated to the same countries in Europe. While in other regions European banks degree as traditional banking. play a smaller role in relation to recipients’ economic size, an accelerated and disorderly retrenchment could still affect their Transmission to Emerging Markets economies. Some emerging economies (for example, Chile and The impact of European bank deleveraging and tighter credit Hong Kong SAR) report accelerated loan contraction by Euro- conditions is being transmitted to the rest of the world through pean banks since late 2011. various channels, such as: Countries that are heavily dependent on banks from the i. Reduced cross-border claims of European banks on the European periphery―Greece, Ireland, Italy, Portugal, and Spain public, private, and banking sectors of emerging market (GIIPS)—are also exposed. The subsidiaries of GIIPS banks that and developing economies; are active in a number of CEE countries and are having large ii. Sales or scale-down of noncore, nondomestic businesses in capital gaps under the EBA stress tests are also particularly vul- host economies; nerable to parent bank retrenchment. Although GIIPS claims iii. Deleveraging by subsidiaries and branches of foreign are generally under 1 percent of GDP for most countries, the banks faced with reduced funding flows from parents Figure 6. Exposure to All European Banks (median, by region) or parent attempts to transfer dividends, capital, or li- quidity to headquarters; and 30 100 iv. Increased costs of borrowing for subsidiaries, either as a foreign claims of European banks 25 80 result of a general worsening of the funding conditions percent of GDP percent of GDP 20 or as increased investor concerns about parents gener- 60 ate anxiety over the banking group’s overall health. 15 A country’s exposure to the risk of European bank de- 40 10 leveraging depends on a combination of factors: the size of 5 20 cross-border claims of European banks relative to the recipi- ent’s economy, particularly where local affiliates play a key 0 0 role in the provision of credit to the private sector but are Q1 2000 Q3 2000 Q1 2001 Q3 2001 Q1 2002 Q3 2002 Q1 2003 Q3 2003 Q1 2004 Q3 2004 Q1 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011 Q3 2011 not systemic to the overall banking group;4 the maturity (hence reversibility) of the claims; whether the local affili- ates rely on a wholesale (cross-border) funding model; and Asia MENA Latin America SSA the capacity and willingness of other participants and mar- other CEE (right) Europe (right) kets to step in. Parent bank retrenchment could destabilize Source: International Monetary Fund, World Economic Outlook and Bank for International the local financial system and affect economic activity, par- Settlements, Consolidated Banking Statistics, table 9A. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 7. Declining Share of Developing Countries’ Claims a set of principles in the Vienna Initiative-II to avoid disor- 74 derly deleveraging in emerging Europe.6 European bank claims to total claims 72 on developing countries Impact on Emerging Market Credit percent of GDP 70 Conditions 68 Euro zone problems are already producing ripple effects 66 around the globe. A recent lending survey by the Institute 64 of International Finance suggests that EMEs also faced 62 tighter credit conditions in the fourth quarter of 2011; the 60 deterioration in lending conditions continued for the third Q1 2000 Q3 2000 Q1 2001 Q3 2001 Q1 2002 Q3 2002 Q1 2003 Q3 2003 Q1 2004 Q3 2004 Q1 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011 Q3 2011 consecutive quarter in 2012:Q1, although less drastically than in the last quarter of 2011 (figure 8). Survey respon- dents in 2011:Q4 explicitly stated that they had been ad- Source: Bank for International Settlements Consolidated Banking Statistics. versely affected by the fallout of the euro debt crisis. While tighter credit standards, reduced loan demand, and rising country median exposures for CEE (to Greek and Italian NPLs have all contributed to the deterioration of credit condi- banks) and for Latin America (to Spanish banks) are relatively tions in EMEs, the most significant factor appeared to be an significant, at a median 7.9 percent and 5.3 percent of GDP, erosion of local and global funding conditions, most markedly respectively. The rapid growth of CEE claims of GIIPS banks in CEE, Africa, and the Middle East (figure 9).7 However, poli- since 2006 is particularly striking. cy measures taken by central banks in emerging and mature Dependence on cross-border flows from European banks economies in recent months (especially by the ECB) are be- is an important channel of contagion. Cross-border bank flows lieved to have improved funding conditions and helped stem (foreign claims excluding the claims of local offices of foreign the deterioration, particularly in CEE. Deteriorating NPLs un- banks in a given host country) are relatively large and have been derlying the tightening of lending conditions is most concern- growing in some regions since 2005, particularly in CEE. The ing in CEE. A number of CEE, Asian, and Latin America sub- claims have declined since 2008, especially by third quarter sidiaries of European and U.S. banks have seen their credit 2011, across most regions (CEE [by US$27 billion], Latin ratings downgraded following rating actions on the parent America [US$20 billion], and Asia [US$35 billion]), and roll- banks. over risk has increased along with a reduction in the maturities Host country banking systems may be vulnerable to par- of claims. Flows to advanced European countries have also de- ent bank attempts to cut back their host operations and trans- creased, driven by a retrenchment from the European periph- fer resources from subsidiaries, potentially triggering mutually ery. At least 50 percent of median cross-border claims across harmful policy responses by host authorities. Some European regions have less than a two-year maturity. banks have been withdrawing, to varying degrees, from CEE, Local affiliates of foreign banks play a large role in many Latin America, Asia, and the Middle East (for example, by cut- EMEs, but their claims declined sharply recently, with regions that rely on a wholesale cross-border funding model being the Figure 8. Bank Lending Condition Indices in EMEs most affected. Foreign bank ownership is prevalent in EMEs, net bank respondents reporting tightening and claims of foreign affiliates (that is, branches and subsidiar- lending condition indices diffusion index (50 = neutral) 70 ies) have grown rapidly since 2005, particularly in emerging 65 Europe, where median claims stand around 40 percent of host 60 country GDP, compared with a low 10 percent in Asia and Latin America. The role of foreign affiliates gradually declined 55 in Africa and the Middle East after 2009. The level of local 50 claims dropped sharply in the third quarter of 2011. Many for- 45 eign affiliates of global European banks are funded in local mar- 40 kets and are more insulated. In Latin America in particular, the 35 regional average of country median L/D ratios of European Q1 2012 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 bank subsidiaries is 92 percent, compared with 123 percent in CEE, making Latin America banks less dependent on parent funding. In February, in a move to reduce the CEE region’s vul- global AFME Latin America nerability to parent retrenchment, European officials, interna- Europe Asia tional financial institutions (IFIs), and private banks agreed on Source: Institute of International Finance Survey. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 9. Drivers of EME Lending Conditions the impact is much smaller because a large portion of the short- net bank respondents reporting tightening fall is covered by capital-raising measures. A range of scenarios drivers of lending conditions analyzed imply a fall of €11–27 billion (1–2 percent of banks’ IIF data index, global EME credit), concentrated mainly in Latin America and Eu- diffusion index (50 = neutral) 75 70 rope. The impact would be €27 billion, if deleveraging occurs 65 fully via the loan book. If, as submitted capital plans currently 60 imply, around 40 percent of deleveraging occurs via loan cuts, 55 the impact is an €11 billion cut in credit. The ultimate impact 50 will vary, based on a number of other factors not incorporated 45 in the analysis; for example, the funding models of subsidiaries 40 35 that supply the local credit, strategic importance of a subsidiary 30 for the host and the parent, and ability of local markets to sub- stitute European bank credit. In all of these respects, Latin Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 America will likely be less affected by European deleveraging, because subsidiaries rely less on parent funding and local mar- credit standards demand for loans trade �nance kets can offer funds. nonperforming loans funding conditions In the longer-term, European bank leveraging likely needs Source: Institute of International Finance Survey. to decline further, with additional impacts on EME credit. Eu- ropean bank assets are still around 18–20 times equity, which ting back on capital-intensive activities, reducing jobs, and is high internationally (compared to about 10 times in the U.S. withdrawing from locations with less profitable operations and banking system). A further fall in leverage could happen higher dollar funding costs). Regulatory constraints and height- through capital increases, but asset reduction may also be need- ened scrutiny by host regulators on banking groups’ ability to ed to reach the desired level, say, 12 times equity. If banks can move capital and liquidity within the group, in turn, make host raise equity by 20 percent―as they have done before―and the operations less attractive and hinder the group’s ability to man- residual deleveraging occurs fully through loan reduction, the age liquidity and credit risks. Some parent banks have report- estimated decline in EME credit could amount to a fairly sig- edly been planning to sell (parts of) these activities—a source of nificant €874 billion (or 46 percent of EME credit). tension that would require close coordination and cooperation between home–host regulatory and supervisory authorities. Conclusions and Policy Implications Some illustrative computations provide a sense of the po- Policy makers have taken substantial steps toward resolving the tentially significant magnitude by which European bank dele- euro area debt crisis, but significant risks remain. The ECB’s veraging could affect emerging market credit. Deleveraging two LTROs have averted a disorderly deleveraging outcome and could happen in two phases: one immediate and one longer helped slow the decline in credit provision to the private sector, term. In the near-term, banks need to adjust their balance but only a limited amount of the liquidity injection has so far sheets to comply with EBA recapitalization requirements. found its way into the real economy. While this may be a lagged Banks with a capital shortfall have €1.35 trillion outstanding in EME credit (about 8.3 percent of their total loans). In a worst- Figure 10. EBA Recapitalization Impact on EME Credit across case scenario, if banks need to meet the full €114.7 billion Simulation Scenarios capital shortfall via 100 percent deleveraging, and if the dele- 300 impact of euro zone deleveraging on veraging is fully via the loan book―proportionately distributed credit reduction in EMs 250 emerging market credit by capital measure (billions of euros) 245.1 over regional holdings―the estimated decline in EME credit could be as much as €245 billion (19 percent of the outstand- 200 ing EME credit)—figure 10. If banks are able to raise capital to 150 130.5 cover half of the shortfall―many banks have announced that 100 they have filled (parts of) the gap―the estimated short-term im- 50 pact on EME credit would be lower, at €131 billion (10 percent 27.1 0 of their outstanding EME credit). 10 20 30 40 50 60 70 80 90 100 The information contained in banks’ submitted capital necessary asset deleveraging via loan book (%) plans, where only 23 percent of the shortfall comes from asset- fraction via asset deleveraging: 50% reduction measures, suggests a much smaller impact on EME fraction via asset deleveraging: 100% fraction via average deleveraging: 10% credit in the short term. With only 10 percentage points of to- tal (23 percent) asset-reduction measures covered by asset sales, Source: Authors’ computations. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise response to policy, continued economic and regulatory uncer- ka is Research Analyst in the Financial and Private Sector Develop- tainties may keep credit demand and supply subdued for some ment Network at the World Bank. Inci Otker-Robe is the Chief time. Funding conditions are still fragile, with significant ten- Technical Financial Sector Specialist in the Financial and Private sions surrounding the periphery and continued worries about Sector Development Network at the World Bank. the adequacy of the firewall against renewed stress and conta- Notes gion. Banks remain under pressure to boost capital and liquid- ity buffers, restore and shrink balance sheets to improve access 1. Some countries introduced additional elements to enhance to long-term funding, and adjust business models toward a banks’ resiliency, including capital surcharges based on riski- more sustainable, yet profitable, equilibrium. ness of banks’ business models, living wills, and greater reliance Meanwhile, additional risks are accumulating. Reduced on deposit funding in extending credit (Austria); countercycli- funding pressures may reduce incentives for sovereigns to re- cal capital buffers and ring fencing between retail and invest- form and for banks to clean up their balance sheets. The en- ment banking (United Kingdom); and heightened liquidity re- cumbered LTRO collateral has increased risk for senior bond- quirements, greater risk management responsibilities, holders, which may hinder unsecured market funding going restrictions on counterparty exposure between large financial forward. Systemic risks may be rising as less or unregulated companies, and living wills (United States). nonbank financial institutions start filling the gap created by 2. The plans propose that around 23 percent of the capital deleveraging banks. shortfall will be covered by deleveraging (asset sales, modeling The policy prescriptions to guard against these risks are changes for computing RWAs, and other deleveraging mea- not new. Restoring market confidence on a sustained basis is sures, including loan reductions). key, not only to ease funding pressures and phase out ECB li- 3. Assuming total assets are on average 2.8 times RWAs, based quidity support, but also to reinvigorate credit to the private on a sample of internationally active European banks, and the sector and put fiscal balances on a sustainable path in the re- estimated aggregate EBA capital shortage of €114.7 billion. gion. Commitment to medium-term fiscal prudence, struc- 4. For example, for Greece, Austria, and Belgium, 77.5, 30 and tural reforms, and restructuring of weak institutions is essen- 23 percent, respectively, of parent company profits come from tial, as is strengthening the crisis firewall. Regulatory and profits in the banks’ CEE operations. UK banks obtain 32 per- supervisory coordination and progress in establishing informa- cent of parent company profits from Asia, and Spanish banks tion and burden-sharing regimes across jurisdictions needs to earn 27 percent of their group profits from Latin America. better align incentives of home-host authorities toward global 5. Including consolidated cross-border claims and local claims financial stability. Rapid progress in implementing key reforms, of foreign affiliates in foreign and local currencies of banks re- understanding and overseeing the shadow banking system, and porting to the BIS. The claims are on a country’s public, private deepening financial markets to provide alternative but safe and banking sectors, with intercompany, parent-affiliate flows sources of funding to the private sector are essential for reduc- netted out. ing regulatory uncertainty and mitigating new risks. 6. Full Forum Meeting of the European Bank Coordination Vi- enna 2.0 Initiative, March 12, 2012, http://web.worldbank. Acknowledgment org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/0,,conte The authors are grateful to Jeff Chelsky, Marilou Uy, and Tunc ntMDK:23142227~menuPK:258604~pagePK:2865106~p Uyanik for their valuable comments and suggestions. iPK:2865128~theSitePK:258599,00.html. 7. Of the banks surveyed, 63 percent of the banks in emerging About the Authors Europe reportedly acknowledged a tightening of credit stan- Erik Feyen is Senior Financial Specialist in the Financial and Pri- dards due to the financial strains in the euro area (http://www. vate Sector Development Network at the World Bank. Katie Kibuu- iif.com/emr/resources+1823.php). The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 7 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise